Question

Suppose Lost Pigeon Aviation is considering a project that will require $250,000 in assets.

•	The project is expected to produce earnings before interest and taxes (EBIT) of $60,000.
•	Common equity outstanding will be 25,000 shares.
•	The company incurs a tax rate of 30%.

If the project is financed using 100% equity capital, then Lost Pigeon’s return on equity (ROE) on the project will be (16.80%, 14.27%, 19.32%, or 17.64%)
In addition, Lost Pigeon’s earnings per share (EPS) will be ( $1.76 , $1.26, $1.68, $1.85 , or $1.51)

Alternatively, Lost Pigeon Aviation’s CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the company’s debt will be 12%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. . Lost Pigeon Aviation’s ROE and the company’s EPS will be________________if management decides to finance the project with 50% debt and 50% equity.
A. 21.42 and $2.14, respectively
B. 30.24 and $2.90, respectively   
C. 27.72 and $2.65, respectively   
D. 25.20 and $2.52, respectively


When a firm uses debt financing, the business risk exposure for the firm’s common shareholders will_____
A. Increase
B. Decrease

Answer 1

If the project is financed using 100% equity capital, then Lost Pigeon’s return on equity (ROE) on the project will be

ROE = EBIT * (1 - Tax) / Investment = $60000 * 0.70 / 250000 = 16.80%

In addition, Lost Pigeon’s earnings per share (EPS) will be

EPS = EBIT * (1 - Tax) / Equity Shares = 60000 * .70 / 25000 = $1.68

Alternatively, Lost Pigeon Aviation’s CFO is also considering financing the project with 50% debt and 50% equity capital. The interest rate on the company’s debt will be 12%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shares outstanding. . Lost Pigeon Aviation’s ROE and the company’s EPS will be________________if management decides to finance the project with 50% debt and 50% equity.

D. 25.20 and $2.52, respectively
ROE = (EBIT - Interest) * (1 - Tax) / Equity Investment

ROE = (60000 - 125000*.12) * (1 - 0.30) / 125000

ROE = 25.20%

EPS = (EBIT - Interest) * (1 - Tax) / Shares O/s

EPS = (60000 - 125000*0.12) * (1 - 0.30) / 12500

EPS = $2.52

When a firm uses debt financing, the business risk exposure for the firm’s common shareholders will increase (Because they have to pay debt holders interest compulsorily)

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